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Why a drop in foreclosure completions is good homebuilders (Part 5)

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Implications for the homebuilders

Increased foreclosure activity affects homebuilders, like KB Homes (KBH), Toll Brothers (TOL) and Lennar (LEN), by depressing real estate prices and competing with new homes. Lower home prices mean lower average selling prices for builders and appraisal difficulties, and a glut of foreclosures means lower sales.

Shadow InventoryEnlarge Graph

As we’ve discussed, one of the biggest negative effects of foreclosure activity is psychological. Foreclosures create blight in that a foreclosed property is unlikely to be kept up, which depresses the values of the properties around it. Foreclosures also remind potential buyers of the risks of investing in real estate, which isn’t a good situation for homebuilders. KB Home actually mentioned on its last conference call that it views consumer confidence as a bigger driver of new home purchase activity than interest rates.

This effect has been apparent in the quarterly earnings reports of homebuilders so far. NVR, which is East Coast–based, reported an increase in sales, but nowhere near West Coast–focused builders, like KB Home (KBH), Lennar (LEN), Meritage (MTH) or Ryland (RYL). Again, the psychological risk factor is at work here. Homebuyers are more likely to be comfortable taking risk when prices are appreciating at double-digit rates or higher. This phenomenon explains why the West Coast has fared so well. On the other hand, in the judicial states like New Jersey, New York, Connecticut, and Florida, there’s still a large inventory of homes in some stage of foreclosure. As a result, prices are still bumping along the bottom and haven’t rebounded. (This also speaks to the fallacy of trying to support home prices by restricting foreclosures—investors focus on expected inventory, not current inventory).

The anticipated supply keeps builders out of these markets, which has negative effects on employment—particularly construction employment. Construction has been expected to lead the economic expansion, and it’s in the hot markets on the West Coast. In the rest of the country, activity is only beginning to perk up or is still stagnant.